Another bubble on the horizon?

The International Monetary Fund (IMF) has projected that the global economy will continue to perform robustly in 2018 as well. Experts have thus started signaling alarm that investors’ enthusiasm propelled by the economy has resulted in their pushing past the asset-price. This could create a dangerous bubble that would threaten the world’s financial stability.  

Background

Post the September 11, 2001 attacks, the US Federal Reserve stimulated the struggling U.S. economy by cutting interest rates to historically low levels. This resulted in a boom in the real estate market. Lenders began to extend mortgages to millions who couldn’t qualify for traditional bank loans. Housing prices therefore peaked in early 2006 and began to decline in 2006 and 2007. Many of the subprime mortgages were affordable in the beginning but rates spiked in 2007. In the meltdown that occurred in the wake of this crisis, several banks in Wall Street had to declare bankruptcies and a global recession followed. It is considered one of the worst financial crises.

In the recent years, the world economy has continued showing signs of global recovery. The Eurozone grew by 0.6% in the three months to September 2017. This was above the expectations set by analysts. According to the data from the Eurostat, the 19 members part of the Eurozone, saw their growth accelerated by 0.6% in the three months to June 2017. The year-on-year growth has increased to 2.1% as compared of 1.9% from the same quarter last year. This is the best number the region has seen in the past five years. Forecasts have also been bullish regarding the growth of the bloc in the near future. IMF has said that the Eurozone GDP will grow by 1.7% in 2018. In 2017, International Monetary Fund (IMF) projected a higher than expected growth for China, Japan and the Eurozone countries like Germany, France, Italy and Spain. Due to the strong performances expected from these nations, global growth is expected to be 3.5%.

The forecast for US, China and other nations in Asia has also been projected to grow in the 2018. This has boosted the performance of stock markets across the world.

Analysis

According to the IMF, the world economy will continue to perform better than previously thought. The body has revised up its forecast for world economic growth in 2018 and 2019. This is partly due to one of the biggest tax reforms introduced in the US. Corporates in particular will be gaining a massive tax cut and this will result saying sweeping U.S. tax cuts were likely to boost investment in the world’s largest economy and help its main trading partners.

The tax cuts would likely widen the U.S. current account deficit, strengthen the U.S. dollar and affect international investment flows, IMF chief economist Maurice Obstfeld said. “Political leaders and policymakers must stay mindful that the current economic momentum reflects a confluence of factors that is unlikely to last for long,” Obstfeld told reporters at the World Economic Forum in Davos. However, even IMF has sounded warnings. IMF Managing Director Christine Lagarde pointed to a “troubling” increase in debt levels across many countries and warned policymakers against complacency.

Junk bonds, increased European debt, increased Chinese debt, bad loans and extreme volatility in trade could all contribute to the economy being negatively affected in the near future. There are some troubling signs. Even thought Europe’s economy is rising, the monetary policy in place is for a region that is still suffering a depression.

Nicholas Spiro, a partner at Lauressa Advisory said, “The most blatant case of mispricing in markets is the volatility trade. Hundreds of billions of dollars are backing bets that volatility in equity markets will continue to remain subdued. The “short volatility” trade now amounts to a staggering US$2 trillion, according to a report by Artemis Capital Management.”

Assessment

Our assessment is that while the world economy is clearly in recovery, governments, analysts and authorities should not ignore the warning signs that are current present. The volatility of market and rising debt in regions like Europe and China should be a cause of concern and ought to be duly addressed. We believe geopolitical events especially North Korea and Iran and instability in the European Union are major threats to markets. The risk is further compounded by asset bubbles, rising interest rates, low yield and unwinding of quantitative easing by central banks. We sense that in a period of extraordinarily low interest rates, investors try to better their yield crowding into ever riskier assets and creating asset valuation bubbles.